Traders’ Take on The Fed Meeting Today
Using the Options Market as a Tool for Evaluating Market Risks
Sitting vs. Trading
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The much-anticipated Federal Reserve September meeting will conclude this afternoon. Traders have been anticipating that this meeting might yield the first interest rate hike in many years. The odds of a rate hike on Thursday have been moving around violently in recent months.
The monthly jobs data has been signaling that the U.S. economy is improving, and after each positive report, the odds of a rate hike increased. But recent volatility in global markets, likely triggered by the potential China slowdown, has lowered the odds again.
At this point, it’s truly anyone’s guess.
Many top hedge fund managers have given their opinions recently:
Goldman Sachs Chief Executive Officer Lloyd Blankfein recently said regarding increasing rates, “I wouldn’t do it unless I was compelled.”
Ray Dalio of Bridgewater Associates has said that a “rate increase will prove to be an epic blunder in the face of a vulnerable global economy.”
Bill Gross, formerly of Pimco, and now with Janus Capital recently wrote, “They should hike rates, but their September meeting language must be careful, that ‘one and done’ represents an increasing possibility—at least for the next six months.”
The top hedge fund managers in the world are as confused about the stock and bond markets as the rest of us. So what do they, and we, do in times like this? Tread very carefully. Don’t force trades just to have some “action.” Similarly, don’t be in a rush to buy the dip or sell the rip.
The options market is a great tool for gauging the risks that the big market players see in the coming days/weeks. By looking at options that expire this week and in the coming weeks, we are able to determine the potential reaction to the upcoming Federal Reserve event.
As of Wednesday afternoon, the options market is pricing in the potential move for the S&P 500 of approximately 2% by the close of trade on Friday. While that seems like a big move, it’s actually not that large, as we have had frequent market movements of 1%-2% over the past month.
Options that expire on September 25 are pricing in the potential of about a 2.7% move in the next week and a half. Again, this seems fairly priced in light of recent volatility.
That said, skew, which is the pricing of big downside and upside risks, is pricing in significant concerns to the downside and little potential for a big upside move. Here is the graph of skew (courtesy of LiveVol) for the S&P 500:
The red line represents options that expire on Friday September 18.
The yellow line represents options that expire on Friday September 25.
The left side of the graph represents out-of-the-money puts, and the right side of the graph represents out-of-the-money calls. What stands out on this graph is that the options market is pricing in huge concerns to the downside and little concern to the upside. This is shown in the graph by the higher prices of out-of-the-money puts (left side of the graph) and lower prices for out-of-the-money calls (right side of graph).
Another way to interpret this skew is to look at prices of puts/calls at equal distances from the current price of the SPY. For example, with the SPY trading at 199.50, let’s look at the prices of puts/calls 3%, 5%, 8% out-of-the-money:
A 3% move in the SPY to the downside and the upside would be to 193.5 and 205.5.
The 193.5 Puts that expire on Friday, September 25 are worth $1.20.
The 205.5 Calls that expire on Friday, September 25 are worth $0.25.
As you can see, the puts are more expensive by $0.95.
A 5% move in the SPY to the downside and to the upside would be 189.5 and 209.5.
The 189.5 Puts that expire on Friday, September 25 are worth $0.65.
The 209.5 Calls that expire on Friday, September 25 are worth $0.03.
As you can see, the puts are more expensive by $0.62.
An 8% move in the SPY to the downside and to the upside would be 183.5 and 215.5.
The 183.5 Puts that expire on Friday, September 25 are worth $0.25.
The 215.5 Calls that expire on Friday, September 25 are worth $0.00.
As you can see, the puts are more expensive by $0.25.
Clearly this illustration of the price of puts versus calls shows that there is concern about a big downside move. That said, puts are virtually always going to be more expensive than calls as traders buy puts and sell calls to hedge their portfolios. Because of the need to buy insurance against a portfolio, I wouldn’t read too much into the prices of puts at extreme price levels such as down 8% in just over one week’s time.
Conclusion:
The pricing of a 2% move in the S&P 500 this week seems cheap to me. That said, the pricing of downside puts 3% and 5% out-of-the-money is definitely a warning sign. On the other hand, the contrarian might take a gamble with “cheap” out-of-the-money calls.
With all of that said, no one knows what the Federal Reserve will do with interest rates, what they will say about the future of interest rates, or how the market will react to any of the various scenarios. If you gave me the rate decision ahead of time, I’m not sure that I, or virtually any trader/hedge fund manager, would know with any great confidence how the market would react in the minutes or hours or days afterwards.
Thus, now’s a time to do more sitting than trading.
